REGULATORY DEVELOPMENTS IN EUROPE: 2013 … · 2016-11-04 · Simultaneously, they continue to...
Transcript of REGULATORY DEVELOPMENTS IN EUROPE: 2013 … · 2016-11-04 · Simultaneously, they continue to...
REGULATORY DEVELOPMENTS IN EUROPE:
2013 UPDATE AND ANALYSIS JUNE 2013
Executive Summary
European policymakers and regulators are focussed on reinvigorating economic
growth and are considering how capital markets and investors can play a greater
role in that regard. Simultaneously, they continue to pursue financial regulatory
reform in response to the financial crisis, seeking to balance near-term growth
requirements with the need for financial stability.
Since 2009, BlackRock has engaged with policymakers in an effort to shape
financial regulatory reform and avoid unintended negative consequences for end-
investors. BlackRock is generally supportive of a regulatory regime that increases
transparency, extends greater protection to investors and facilitates responsible
growth of capital markets, provided it also preserves consumer choice and has
benefits that exceed implementation costs.
This ViewPoint updates our 2012 overview and analysis of regulatory
developments in Europe. It details the different components of financial regulation
and their implications for investors. Topics covered range from investor protection,
investment products and execution venue choices through to market liquidity and
investment profitability.
Over the past four years, policymakers have focussed intently on banking, but
have started progressively to turn their attention to the asset management and
fund industry. Agreement has been reached on a number of important initiatives
(e.g., rules requiring central clearing of derivatives and a common approach to
short selling), and resolution is close on others (e.g., the Markets in Financial
Instruments Directive, or MiFID, the Capital Requirement Directive IV, or CRD IV,
and the Market Abuse Directive, or MAD). Many of these new rules will have
important implications for end-investors.
Additional regulatory initiatives were launched in 2012, including a further review of
the Undertakings for Collective Investment in Transferable Securities (UCITS) and
new proposals on retail investor protection, all currently under negotiation. Also,
since our June 2012 ViewPoint, the regulatory agenda on “shadow banking” has
emerged and the political debate on the Financial Transaction Tax (FTT) has evol-
ved significantly. An Action Plan on European Company Law and Corporate
Governance has been launched and long-term investing has become an important
area of policy focus. Long-term investing will be at the top of the EU regulatory
agenda for the next couple of years. A number of initiatives, such as FTT and the
imposition of bank regulation on market finance, which undermine broader policy
themes, are likely to be reconsidered in the near future given their negative impact
on growth.
The current regulatory landscape is still characterised by high uncertainty, which
continues to inhibit investment in Europe. BlackRock remains committed to work
with policymakers to ensure the voice of the end-investor is heard in this process.
The opinions expressed are as of June 2013 and may change as subsequent conditions vary.
This ViewPoint is structured in
four parts:
1. Product/Fund Management
& Investor Protection 2
2. Market Structure 9
3. Taxation 14
4. Investment & Asset Allocation 17
Product/Fund Management & Investor
Protection
AIFMD
UCITS
Investor Protection
“Shadow Banking” or Market Finance?
Market Structure
OTC Derivative Markets
MiFID II / MiFIR
Financial Benchmarks
Taxation
Financial Transaction Tax
FATCA
Investment & Asset Allocation
Bank Regulation
Solvency II
IORPD
Corporate Governance
Market Abuse Directive
Audit Regulation
Long-Term Investing
Alternative Investment Fund Managers
Directive (AIFMD)
In the wake of the financial crisis, the European Commission
(EC) sought to reshape and harmonise the management and
marketing regulation of any Alternative Investment Funds
(AIFs) managed or distributed in the European Union (EU).
The AIF Managers Directive (AIFMD) introduces a
comprehensive framework for the oversight and regulation of
AIFs. The aims are to reduce potential risks to the overall
financial system, increase investor protection and provide
greater transparency to investors and regulators.
The scope of AIFMD is extremely broad. The definition of
AIFs includes all non-UCITS funds (with the exception of
insurance products) wherever domiciled, which are either
managed or marketed to investors within the EU. The
definition of AIFs includes not only hedge funds and private
equity funds, but also real estate funds, Luxembourg
Specialised Investment Funds (SIFs), Irish Qualifying Investor
Funds (QIFs), Dutch Fonds voor de Gemene Rekening
(FGRs), German Spezial fonds, UK Investment Trusts, UK
charity funds, UK Non-UCITS Retail Schemes (NURS) and
UK unauthorised unit trusts. AIFMD also captures US bank
collective trusts and US 40 Act funds marketed within the EU.
Only non-EU investment funds managed by non-EU
managers and not marketed into the EU are excluded from
the scope.
The greater transparency provided will assist professional
investors (such as pension funds and insurance companies)
in developing more standardised due diligence programmes
and promote greater comparability of AIFs. Prospectuses,
other offering documents, reports and accounts will cover
disclosure of key issues, such as management structure and
governance, scope of liabilities/duty of third-party service
providers and management, risk liquidity and leverage profiles
and manager remuneration.
Marketing Passport and Private Placement Regimes
AIFMD will herald important changes to the marketing of AIFs
in the EU. From 22 July 2013 onward, it will provide
authorised EU AIF managers with the ability to market EU
AIFs to professional investors across the EU using an AIFMD
marketing passport. This means potentially greater choice for
EU professional investors wishing to invest in EU AIFs.
It is anticipated that the AIFMD marketing passport will
operate in a similar way to the existing UCITS marketing
passport, save that the AIFMD marketing passport is for
professional investors alone.
The marketing passport will not be immediately available for
non-EU AIFMs/AIFs. Subject to further European Commission
and European Securities and Markets Authority (ESMA)
approval, non-EU AIFMs/AIFs may become eligible for the EU
marketing passport beginning in 2015. In the meantime, both
non-EU and EU AIF managers will be able to market non-EU
AIFs subject to local private placement regimes (PPRs) in
certain EU countries, particularly in the UK and Netherlands.
However, many other EU countries, such as France and Italy,
do not have a PPR, meaning active marketing will not be
possible. It should also be noted that in the future, certain EU
countries may make their PPR more restrictive or potentially
close it altogether.
Under the Directive, non-EU AIF managers privately placing
non-EU AIFs must comply with transparency provisions to
investors and regulators, but are exempt from the remainder
of the Directive. For example, a Cayman hedge fund
managed by a US-based manager can still be marketed
under local private placement if registered to do so and
subject to these additional transparency and reporting
requirements. AIFMD imposes specific requirements on third-
party distributors, such as private wealth managers, to ensure
non-EU managed non-EU AIFs that they market meet the
new transparency and reporting requirements.
Reverse Enquiries
Reverse enquiries is the process by which investors approach
fund/investment service providers with specific requests
tailored to their needs and investment preferences, and not as
a result of marketing received from those providers. Reverse
enquiries are technically out of the AIFMD scope. Non-EU AIF
managers will have to show clear evidence of reverse
enquiries to be free from complying with the PPR of the
relevant European country and the associated transparency
and reporting requirements.
Other Issues Affecting Investors
AIF investors will benefit from depositaries’ greater focus on
due diligence and account set-up. Enhanced requirements
may mean depositaries will no longer provide custody
services in certain markets. However, in such cases,
managers may be able to offer indirect and synthetic
exposure to such markets, leading to counterparty exposure
rather than custody risk.
Product/Fund Management
& Investor Protection
[ 2 ]
Reforms of Undertakings for Collective
Investment in Transferable Securities (UCITS)
UCITS remains one of Europe’s greatest regulatory
successes, as it is widely promoted cross-border within and
outside the EU. Policymakers have proposed a significant
number of further reforms of UCITS. Taken together, these
reforms will significantly affect the UCITS landscape and
investors in UCITS funds. The aim is to ensure investors
continue to benefit from increased transparency and
enhanced protection, although this could potentially reduce
flexibility and the ability of investors to reach all their
investment goals.
UCITS V Directive
The UCITS V Directive focuses on the remuneration of asset
managers and the role and structure of depositaries, as well
as the extent to which such depositaries should be liable for
assets held in custody, including those held by a third-party
sub-custodian. The Directive is expected to come into force in
2015. Key provisions that could impact investors are:
Remuneration: The text aims to align remuneration
provisions with those in CRD IV (for credit institutions) and
AIFMD. Managers’ ability to align remuneration with long-
term performance could potentially be restricted if the
European Parliament’s proposal for a cap on the amount of
variable remuneration payable is adopted.
Depositaries’ liability: Depositaries will be held strictly
liable for assets held in custody even when appointing a
third-party sub-custodian – leading to restitution of assets
that are lost or stolen. Depositaries will also have enhanced
duties to oversee assets not held in custody.
Depositaries’ structure: Only authorised and supervised
credit institutions and MiFID investment firms will be able to
act as depositaries. It remains to be seen whether other
investment firms subject to adequate prudential supervision
will also be able to act as depositaries. If they are not, the
choice of depository will significantly reduce in the key
jurisdictions, where fund promoters set up UCITS,
The Directive seeks to ensure greater consistency in the
treatment of the depositary’s duties. Under UCITS V, we can
expect greater alignment with the investor protection
measures recently agreed in AIFMD – levelling the playing
field between UCITS and AIFs in this area. Also, as with
AIFMD, we will need to carefully consider whether changes in
depository model will lead to increased costs of servicing
specific markets or a reduction in direct market coverage.
ESMA Guidelines on Exchange Traded Funds (ETFs) and
Other UCITS Issues
ESMA Guidelines on ETFs and other UCITS Issues came into
force on 18 February 2013 for new funds, with transitional
provisions in place for existing funds until February 2014.
Member states and firms are expected to comply with the
Guidelines. ESMA has introduced a number of common
standards that aim to protect investors, including:
Enhanced level of information that should be communicated
with respect to index-tracking UCITS and UCITS ETFs on
index composition, and for all UCITS, details of
counterparty identification and diversification.
Provisions on over-the-counter (OTC) derivative
transactions and efficient portfolio management techniques,
including rules on collateral management, securities lending
and repo/reverse repo arrangements as well as enhanced
disclosure requirements.
Criteria for financial indices in which UCITS invest.
ESMA also recently clarified that non-UCITS funds are only
eligible for inclusion in UCITS if they meet strict equivalency
requirements or can meet the requirements to be treated as
an eligible security. These latest requirements may lead to
some restructuring of existing portfolios by the end of 2013.
Further UCITS Reforms
The EC published a consultation on the future of UCITS in
July 2012 covering a broad range of topics from eligible
assets; the use of derivatives; the use of efficient portfolio
management (EPM) techniques such as securities lending,
repo and reverse repo; the treatment of centrally cleared OTC
derivatives and extraordinary liquidity management tools; a
depositary passport; money market funds (MMFs) and long-
term investing. No specific legislative proposals have yet
been put forward, although an initiative on MMFs is expected
in the second half of 2013.
Political State of Play/Implementation
The AIFMD Level 1 text was published on 8 June 2011
and Level 2 implementation measures were formally
adopted in December 2012 by the EC.
Member states have until 22 July 2013 to implement
AIFMD into national law in their jurisdictions. A transition
period allows AIF managers up to a year in which to
apply for the necessary variation of permission,
authorisation or registration in their home member state.
Applications must be received before 22 July 2014.
Member states are currently drafting their national laws.
In parallel, ESMA is in the process of negotiating
supervisory cooperation arrangements with regulators in
various non-EU states. National regulators must execute
such arrangements with non-EU supervisory authorities
to maintain their national private placement regimes.
[ 3 ]
Below we outline some of the proposals to enhance existing
UCITS regime and their potential implications for investors.
Other issues, such as EPM techniques, MMFs and long-term
investing, are covered elsewhere in this ViewPoint.
Eligible assets and use of derivatives: The current
UCITS framework affords retail investors high levels of
protection and allows a wide range of strategies to be
carried out within a rigorous risk management framework.
Potential restriction on the use of derivatives (e.g., by
restricting the use of Value at Risk, or VaR) could limit fund
managers’ ability to effectively manage investors’ risk
exposures. We believe further disclosure on the impact of
the use of derivative strategies on the risk profile of a
UCITS and more standardised reporting on risk and
leverage would be beneficial.
Extraordinary liquidity management rules: Further
guidance on liquidity management may be adopted to deal
with liquidity issues such as those arising from some
investor redemption requests. This is closely linked to
UCITS requirements to maintain investment in sufficiently
liquid assets to meet on-going redemption requests. The
consequence of meeting redemptions in all circumstances,
especially in the case of large redemptions, is that a UCITS
may have to dispose of a significant amount of assets at
times when market liquidity is relatively thin, thus causing
re-pricing of assets and artificially depressing the net asset
value (NAV) of the UCITS while incurring dealing costs to
the detriment of non-redeeming investors. UCITS have a
set of existing tools to manage liquidity risks (please refer
to the box below). BlackRock supports the emphasis
placed on portfolio constructs and on enhancing liquidity
rules on underlying assets but believes measures such as
capital buffers will be counterproductive.
Additional liquidity safeguards in ETF secondary
markets: Existing rules covering market disruptions and
volatility events for all traded securities are sufficient to
ensure the efficient functioning of the secondary markets.
However, an independent multi-dealer model, with many
approved market makers and authorised participants, would
ensure the best possible provision of liquidity for investors
without compromising the rights of long-term fund holders.
Investor Protection
Investors’ trust in the financial system has been shaken by
the financial crisis, which has revealed some weaknesses in
investor protection related to the quality of advice, the sale of
products inappropriate to investor needs, and lack of
transparency and information. This comes at a time when
investors are also bearing increasing responsibility for the
health of their financial futures, particularly in the retirement
phase – when saved assets begin to decumulate. Clearly, it is
critical to preserve choice for investors to maintain a level
playing field for different product providers and advisory
models, under the umbrella of consistent, transparent and
appropriate regulatory protection.
Investor Protection Legislation Currently Under
Discussion or on Implementation
Retail Distribution Review (RDR): The UK has taken the
lead on regulatory actions to improve consumers’ protection
when purchasing investment products with the development
of the new RDR. This will abolish commission payments
from product providers to their distributors and replace them
with fees for advice to be agreed upfront with the client. The
RDR is influencing the future of distribution in many
European countries (see Figure 1) and has influenced the
thinking of the Markets in Financial Instruments Directive
review (MiFID II) and Regulation (MiFIR) on EU-wide
initiatives on investor protection. Similar legislation is due to
be put in place in the Netherlands in 2014. Regulator
discussions of similar proposals are under way in Germany
and Sweden.
MiFID II & MiFIR: The European Commission’s proposals
for the review of the MiFID put forward a number of ideas
concerning investor protection, particularly related to duties
of distributors and advisers with a greater focus on the
ability to pay commission. At a pan-European level, MiFID II
may well ban inducements paid to independent financial
advisers, but allow product providers to continue to pay
commissions to tied or restricted advisers, though the
option is left to individual member states to apply a tighter
regime.
Independent advice is defined as providing an assessment
of a sufficiently large number of financial products
diversified by type, issuer or product provider. Advising on a
limited range of product types and/or products offered by a
limited number of product providers is unlikely to be treated
as giving independent advice.
In the Interests of Investors
UCITS currently have the following levers available to
protect shareholders’ interests in redemptions:
Prior agreement: Provides for a phased approach to
redemption to avoid diluting the value of assets of
remaining shareholders.
Prior notice: Allows managers more time to seek
liquidity in the market to meet redemption requests.
In specie redemptions: Permits assets to be redeemed
in kind rather than having to be sold. Useful if investors
are seeking reallocation of existing portfolios rather than
cash.
Deferred redemption: Allows large trades to be
deferred when the size means the trade could not
realistically be executed in markets in one day. A UCITS
may defer redemptions that exceed 10% of NAV.
[ 4 ]
The review of MiFID also aims to provide greater regulatory
oversight over the launch and on-going distribution of
investment products.
Key Investor Information Document (KIID): The launch
of the KIID in the UCITS IV Directive was an important step
toward achieving meaningful transparency for investors.
The KIID aims to provide a consistent framework for
disclosure across products and is expected to become the
benchmark for disclosure standards for all other retail
products. In particular, the KIID establishes and requires a
simple risk gauge from 1 (low) to 7 (high) called the
Synthetic Risk and Return Indicator (SRRI).
Packaged Retail Investment Products (PRIPs): Building
on the UCITS KIID, the PRIPs Directive aims to enhance
transparency and disclosure related to retail investment
products via the provision of easily accessible product
information produced to common standards in the form of a
Key Information Document (KID).
PRIPs cover a wide range of products – from structured
deposits, through national non-UCITS retail funds, AIFs,
structured products and insurance products, through to
long-term retirement products. It remains to be seen how
the PRIPs Directive will bring a level playing field across
competing bank, asset management and insurance-
packaged products, especially in terms of disclosing
product and distribution costs.
Insurance Mediation Directive (IMD) review: The
objective of the IMD review is to enhance protection of
insurance companies’ customers. Although the EC’s aim
was to provide common standards across insurance and
investment products, there is a risk that the final text may
end up having significant differences from MiFID. For
example, it is still unclear whether IMD will end up banning
commission for independent financial advisers or
significantly enhancing existing disclosure of the insurance
requirements.
Implications for Retail Investors/Customers
We believe these measures could have a number of positive
implications for retail investors:
The removal of commissions in the UK RDR and any
perceived or real bias in the system means a significant
number of products will be placed on an equal footing. This
is likely to make advisers in the UK less transaction-driven
and more service-orientated in their effort to win and retain
clients, which should lead to better-quality advice and
greater price competition. As a result, advisers may turn to
greater risk profiling, leading to a closer alignment between
clients’ investment goals and their risk appetite. Investors
will also benefit from the higher level of expertise required
for financial advisers.
The new EU-wide KID will give retail investors more
transparency on details of any PRIP. It establishes a level
playing field across retail products by providing clear and
simple investment information to investors – helping them
to make better-informed decisions.
However, the new directives and regulations could also pose
a number of unintended negative consequences for retail
investors.
Post-RDR, many investors in the UK may not be willing to
follow the move to upfront charging for advisory services
and pay advisory fees. There is a risk that fees will become
important criteria for screening investments. This could lead
to less-affluent consumers receiving no advice at all or
adopting a “do-it-yourself” approach to selecting their
investments, potentially leading to poorer outcomes. This
could persist until advisers develop charging models that
meet the needs of these clients.
The RDR could accelerate the trend to offer more cost-
effective solutions to clients via passively managed
products such as ETFs. This could also lead to an increase
in discretionary services and in-house solution suites for
clients seeking a “one-stop-shop” style offering, as well as
the development of risk-based ready-packaged multi-asset
products offering a time-saving device for advisers who
cannot justify customised portfolio construction for cost-
conscious clients. The challenge is to provide diversified
exposure through a simpler and lower cost approach than
in many traditional core portfolio allocations.
The RDR may introduce regulatory arbitrage. While
commissions would be precluded in the direct sale of
investment products, they are being retained in the
wrapped life and pension business. As such, advisers may
be incentivised to move their clients out of traditional
investment products into insurance-wrapped investments in
order to secure commissions on contractual products.
Flows to multi-manager and multi-asset “wrapped” products
could also increase, as certain independent financial
advisers transition to a discretionary model in which they
can retain trail commission post-RDR.
Banning commissions paid to independent financial
advisers who operate in an open architecture environment
and not commissions to restricted financial advisers could
encourage distributors to move to a commissions-paying
closed-architecture model offering a simplified range of
products where investors no longer have access to “best-in-
class” products. This would restrict product choice and
reverse the benefits of product and price competition that
open architecture has brought.
[ 5 ]
With regard to the PRIPs Directive, it is essential for
investors to benefit from a level playing field in terms of
disclosure on details of the diverse range of investment
products including all PRIPs, UCITS, bank and insurance
products. This would help investors draw better
comparisons and make investment decisions on the basis
of clear and consistent information.
The consequences of RDR for UK investors are likely to be
similar for EU investors once the MiFID II has been translated
into national law around mid-2015. More significantly though,
the adoption of MiFID II and further RDR-style legislation in
continental Europe could lead to fundamental changes to the
way in which investment products are distributed. There are
two main models of distribution:
The open architecture where an adviser can select
products from a wide range of product manufacturers for
her clients; and
The closed or integrated architecture where an adviser
selects products from a single manufacturer with which she
is linked – typically a bank or insurance company.
COUNTRY PROVISION
Netherlands Ban on commissions in 2013 applies to insurance, mortgage & protection products and will be extended to
funds and other asset management products in 2014 ahead of MiFID II coming into force. However, key bank
distributors are moving ahead of regulation and transitioning to commission-free share classes, frequently in
index funds.
Belgium Recent legislation would ban payment of commissions for discretionary portfolio management and to
independent financial advisers, but not to tied or restricted advisers.
Sweden Regulators have announced they are reviewing retail distribution, explicitly referring to the UK’s RDR.
Germany Changes to business practices in the financial advisory segment have been confined to information/disclosure
requirements. Pending any changes in MiFID II, the focus has been on permitting the payment of
commissions subject to increased levels of transparency as to the cost of advice, though there is much
discussion by BaFin of a more radical regime, including banning commission payments to independent
advisers. In the medium term, any moves to follow the Netherlands and the UK by banning commission
payments across the board are only likely to gather speed with implementation of MiFID II.
Italy Italy banned payment of commissions for discretionary portfolio management at the time of MiFID II. Italian
regulators are following the debate over commissions, but currently there are no specific plans focussed on
distribution. Distributors have no plans to move ahead of regulation.
France France supports a ban on payment of inducements for discretionary portfolio management. The French
regulator has expressed concerns that a ban on commissions will lead to increased churning of investment
products. Instead, the regulator has focussed on investor protection in the form of greater disclosure rules for
all savings products.
Figure 1: LIKELY INVESTOR PROTECTION PROVISIONS IN KEY EU JURISDICTIONS (EX-UK)
Political State of Play
RDR was initiated on 31 December 2012 and will be
fully in place by 31 December 2013.
Debate in MiFID II and MiFID on investor protection is
still on-going and should be complete in the course of
2013. A ban on commission for independent financial
advisers is expected. However, it is still too early to tell
whether the rest of Europe will move to full RDR-style
charging for all advisers. Alternative responses could
focus purely on the independent sector, require
enhanced disclosure of adviser fees or adopt a hybrid
approach involving, for example, greater use of cash
accounts. Implementation of the MiFID review is
expected by mid-2015.
Please see related ViewPoint, “Retail Distribution Review:
Looking Ahead” for more on this topic.
[ 6 ]
[ 7 ]
Others are concerned that sponsor support of CNAV MMFs
could weaken the bank’s balance sheet (where the MMF
promoter is part of a banking group). We believe any
regulation of MMFs must pass two basic tests. First, it must
preserve the core benefits of the product. The benefits to
investors in MMFs are well-known: diversification, ease of
operation and accounting, and market-competitive returns.
Often overlooked are the benefits to borrowers in the capital
markets (e.g., issuers of commercial paper, certificates of
deposit and sovereign and supranational securities). MMFs
can provide a more stable, cross-border source of funding
that is able to respond rapidly and in a market-based manner
to the needs of borrowers. The second test is that regulation
must address the issue of runs. In 2008, for the first time in
history, MMFs investing primarily in bank debt experienced
unprecedented redemption demands, coupled with a
complete failure of market liquidity as investors fled any
exposure to banks and mortgage securities.
Converting from CNAV MMFs to VNAV MMFs fails the
second of the two tests, as both types of MMFs experienced
substantial redemptions during the financial crisis. The run on
MMFs in 2008 did not represent investor fears regarding the
pricing structure of one type of MMF, but rather, their concern
regarding the creditworthiness of financial institutions in which
the MMFs had invested. At the same time, all those investors
requiring CNAV MMFs for tax, accounting or ease of
operation, would lose this investment option and be forced
instead to invest in VNAV MMFs, separate accounts or
directly in bank deposits or market securities.
Similarly, while capital should make MMFs marginally safer,
it will not solve the core issue that regulators are trying to
solve: runs. In almost all conceivable scenarios, it will either
be unnecessary or insufficient. For idiosyncratic events, most
sponsors historically have had sufficient access to capital to
protect their funds. For true systemic market failures, the
amount of capital necessary to fully protect the funds would
be so large as to destroy the commercial viability of the
product.
In our view, standby liquidity fees, combined with consistent
asset standards and increased transparency, are the best
regulatory solution that will both preserve the benefits of
MMFs for investors and borrowers, while definitively stopping
a run. We recommend that, once an objective trigger has
been met, a redemption fee of 1% be imposed on
withdrawals. For those who want, but do not need, their
money, this would act as a disincentive to run.
“Shadow Banking” or Market Finance?
Following the financial crisis of 2008, policymakers, both
globally and in Europe, have focussed on regulatory reforms
of banking and, in particular, repair of bank balance sheets.
At the same time, policymakers have been considering
“shadow banking” – in essence, credit intermediation,
sources of liquidity and funding, especially where they
involve leverage and maturity transformation – that takes
place outside of the traditional banking system. In addition to
mitigating systemic risk where it may occur, or when
transmitted from outside the banking sector, a key policy
driver behind the “shadow banking” agenda is the future
avoidance of regulatory arbitrage – in other words, a
regulatory approach focussed on “same risk, same rules”.
According to the most commonly understood definitions of
the term, “shadow banking” would include MMFs, securities
lending and repo and securitisation. BlackRock has been a
leading advocate in refining the nomenclature of this debate.
Specifically, “shadow banking” may be appropriate for certain
off-balance-sheet structured finance entities sponsored by
banks (principally, term finance entities such as special
Investment Vehicles - SIVs), but “market finance” better
captures the positive complementary role in funding the real
economy and contributing to the liquidity and stability of
financial markets performed by activities such as securities
lending, repo, securitisation and investing in MMFs.
We are concerned about the potential for unintended ne-
gative consequences from inappropriately calibrated
prudential regulation applied to MMFs, securities lending
and repo.
MMFs – Potential Changes Having the Most Implications
for Investors
Policymakers globally continue to grapple with the regulation
of MMFs in the wake of the financial crisis. The International
Organisation of Securities Commissions (IOSCO) and the
Financial Stability Board (FSB) have adopted global
principles for the regulation of MMFs, the US Securities and
Exchange Commission (SEC) issues a proposal in June and
the EC are expected to make a formal proposal by July
2013. The final rules may require mandatory conversion of
some or all constant-NAV (CNAV) MMFs to variable-NAV
(VNAV) MMFs and some CNAV MMFs may be
“strengthened” by capital buffers. Some policymakers are
concerned that mass client redemptions from MMFs,
especially CNAV MMFs, could create funding issues for
banks.
Securities Finance – Potential Changes Having the Most
Implications for Investors
Securities lending generates incremental returns for
investors’ portfolios – contributing to overall investment
performance. Investment vehicles make short-term loans of
their securities to banks and broker-dealers, who, in return,
provide collateral that is in excess of the value of the
underlying loans. Securities lending also has wider benefits
for financial markets, as it provides liquidity that helps to
improve settlement efficiency and contributes to tighter
trading spreads for investors.
Repo provides a source of short-term capital, facilitating
liquidity and, therefore, efficient and stable financial markets.
While securities lending and repo transactions share some
common features, important differences include different
demand drivers, stakeholders and levels of post-trade
complexity. For example, repo transactions are always
related to financing needs, either to invest cash or to raise
cash, while securities lending transactions are normally
driven by the need to settle short sales and only occasionally
are motivated by financing needs.
Policymakers recommend increased fund disclosures to
investors on securities financing transactions. We support
this initiative, which would help ensure investors are fully
informed of the risks and potential returns involved in these
activities. However, the high level of transparency and
detailed transaction-level information that may be required
from asset managers may be of little value for investors and
potentially could be confusing or distracting. The disclosures
proposed would provide investors with a significant amount of
data about these activities when compared with the primary
investment strategies used by the fund (e.g., the identity of
counterparties; a number of repo, reverse repo, and
securities lending data breakdowns; re-use and re-
hypothecation data; information on any restrictions on type of
securities; number of custodians and the amount of assets
held by each; and the way securities received by the
counterparty are held). This could divert investors’ focus from
the primary investment strategies that are truly material.
Policymakers also recommend the regulation of the use of
collateral, possibly including a mandatory minimum haircut.
If applied to the broadest scope of securities finance
transactions, we are concerned this may unduly restrict
market participants’ ability to make appropriate risk-based
determinations regarding collateral, to the ultimate detriment
of the end-investor. By contrast, an appropriate regulatory
floor of haircut as applied to all participants in these markets
would be a beneficial “best practice” and would still permit
investors or their investment managers to make risk-informed
decisions regarding the level of haircut they believe is
appropriate for a given loan or a given counterparty. An
investor may reasonably choose to take a lower haircut on
collateral from a high-quality counterparty, or when the
collateral used is highly liquid or highly correlated with the
securities on loan. We question whether mandatory haircuts
on top of that level would achieve more good than the
possible danger of becoming the de facto norm. Higher
mandatory haircuts may seem appropriate from a systemic
risk perspective, but would reduce or eliminate the
attractiveness of the transaction for investors and the
counterparties. The likely reduction in market liquidity as well
as the reduced income to investors could outweigh any
possible benefits.
With regard to (non-cash) collateral valuation and risk
management suggested by policymakers, daily mark-to-
market and the collection of variation margin for exposure to
counterparties would be very beneficial from a risk
management perspective and a greater improvement to
existing processes than a minimum haircut requirement. Also,
central clearing might be an appropriate way to mitigate the
counterparty credit risk for highly standardised repo
transactions, but not for other less standardised repo
transactions as well as securities lending.
[ 8 ]
Political State of Play
The FSB’s final recommendations on securities lending
and repo are expected in September 2013.
The EC is expected to issue a proposal on MMFs by the
summer 2013. Revisions to regulation governing
securities finance (securities lending, repo and reverse
repo) will be addressed by the proposed Securities Law
Legislation and a further review of UCITS, expected
later this year or in 2014.
OTC Derivative Markets Regulation
The 2008 financial crisis, and significant losses suffered by
financial institutions’ OTC derivative business, revealed
weaknesses in these institutions’ ability to monitor their
counterparty credit risk. The G20, followed by policymakers
globally, therefore mandated that standardised OTC
derivative contracts must be cleared through central
counterparties (CCPs), whereas non-standard derivative
contracts would continue to be traded bilaterally and subject
to various risk mitigation obligations and higher capital
requirements. OTC derivative contracts, whether centrally
cleared or not, would be reported to trade repositories.
Central Clearing of OTC Derivatives
Central clearing is the process by which financial transactions
are cleared by a CCP, which becomes the buyer to the seller
and the seller to the buyer of the financial contract. Central
clearing of OTC derivatives mitigates counterparty credit risk
– giving counterparties the opportunity to maintain existing
positions and collateral in the event of defaults – and
ultimately reduces systemic risk.
Scope of the Central Clearing Requirements
In Europe, the European Market Infrastructure Regulation
(EMIR), adopted into law in mid-2012, legislates for
mandatory central clearing of eligible OTC derivatives for all
financial institutions and a number of non-financial institutions
subject to certain conditions. Pension funds were granted an
exemption for three to six years, but it is anticipated that a
number of them will voluntarily choose to clear centrally in
order to benefit from the counterparty credit risk mitigation.
Central clearing will be mandatory only for new transactions
of eligible products, although front loading1 also may be
required. The initial focus has been interest rate swaps and
credit default swaps. Inflation swaps, swaptions and total
return swaps are not currently supported by any CCP in
Europe, although several are working toward broadening
their product scope to include these derivatives over the next
few years.
Investor Considerations
EMIR includes measures aimed at protecting investors. The
final rules allow for “individual client segregation” within CCPs
whereby:
Assets and positions (including excess margin) are
recorded in separate accounts;
Netting of positions recorded on different accounts is
prevented; and
Market Structure
[ 9 ]
Assets covering the positions on one account may not be
used to cover losses connected to positions on another
account.
EMIR also gives meaningful representation to the buy-side on
the risk committee of the CCP, which makes decisions of
fundamental importance to the buy-side, such as which
products may be cleared, details of client account
segregation, pricing, transparency and default procedures.
However, central clearing also poses a number of issues for
investors. For example, fragmentation between eligible and
non-eligible OTC derivatives will be problematic for portfolios
containing both, where these have historically shown some
level of inverse correlation (e.g., interest rate and inflation
swaps). Previously, when considered in combination, the
changes in value of these portfolios may have displayed
some level of offsetting, reducing the volatility of any collateral
requirements. This benefit is lost when each portfolio is
considered in isolation.
Other examples include the opportunity cost of posting initial
and variation margin and the fees payable to the CCP,
clearing and executing brokers. Importantly, only cash will be
eligible as variation margin at the CCP, while the scope of
eligible collateral for initial margin is limited to cash and high-
quality liquid assets such as government bonds and the like.
Therefore, investors will need to have sufficient cash and/or
eligible assets available to meet the requirement and potential
future increases, which might be volatile from one day to the
next.
Risk Mitigation for Uncleared OTC Derivatives
EMIR requires that financial counterparties and non-financial
counterparties (meeting certain conditions) that enter into
uncleared OTC derivative contracts put in place certain risk-
mitigation arrangements. These include:
Timely confirmation: Trades will have to be confirmed,
where available by electronic means, as soon as possible
and at the latest within the specific timelines that range from
one to seven days, depending on the derivative class and
the date when the trade was concluded. In addition,
financial counterparties will need to have procedures in
place to report on a monthly basis to the relevant
competent authority the number of unconfirmed OTC
derivative transactions that have been outstanding for more
than five business days.
Daily mark-to-market valuations: Financial counterparties
and non-financial counterparties exceeding the clearing
threshold must mark-to-market (or mark-to-model where
marking-to-market is prevented by market conditions) the
value of outstanding contracts on a daily basis.
Dispute resolution: Counterparties must agree to detailed
procedures and processes in relation to the resolution of
disputes.
Portfolio reconciliation and compression:
Counterparties must agree to terms on which portfolios are
to be reconciled. Counterparties with 500 or more
uncleared derivative contracts outstanding with a
counterparty must have procedures in place to conduct
portfolio compression.
BlackRock supports and already exceeds the majority of the
requirements as part of its on-going risk management
process. The daily valuation of positions on a mark-to-market
basis and reconciliation of positions and collateral is already
standard practice. Electronic confirmations are used to
confirm most OTC trades within a day or two of the trade
taking place. Unconfirmed transactions (either due to a
necessity to use paper confirmation for certain asset classes
or because of a disagreement of terms between the two
counterparties) are monitored and reported internally on a
daily basis with any trades outstanding for longer than five
business days being highlighted on an additional internal
report so they can be prioritised. We make this information
available to a competent authority as and when we are
required to do so by such competent authority.
Trade Reporting Requirement
EMIR also requires that any derivative contract concluded,
modified or terminated be reported to a Trade Repository
(TR). The obligation to report will affect almost all participants
in derivative markets (both listed and OTC) and represents a
significant change to the current transaction reporting regime.
There are over 60 data fields that may require reporting.
These include the value of a contract and collateralisation,
and for the first time, lifecycle events such as option expiries
will be subject to the reporting requirements. Some
information can be reported by a single party, while other
fields must be reported by both sides of the trade, although
this can be delegated to the counterparty or a third party.
BlackRock will seek to either report directly or have a broker
report on its behalf where possible in order to remove any
requirement on the underlying client.
The reporting requirements will be phased in by asset class
with interest rate swap (IRS) and credit default swap (CDS)
contracts being reported 90 days after the TR is authorised,
with September 23 as the earliest date possible.
Higher Capital Requirements for Uncleared OTC
Derivatives
The Capital Requirement Directive IV and Regulation (CRD
IV/CRR), which aim to implement Basel III capital and liquidity
standards in the EU, require credit institutions to hold higher
capital requirements against their uncleared OTC derivatives
positions. Basel III introduces an additional charge, the so-
called Credit Valuation Adjustment (CVA) risk capital charge,
which banks will have to keep as a provision for the
deterioration of the creditworthiness of a counterparty. In
general, the CVA risk charge will be higher for bilateral trades
with any of the following characteristics: long-dated
derivatives, directional risk profiles, uncollateralised
exposures, low-rated counterparties (due to higher probability
of default) and counterparties with no liquid CDS market –
typically the type of trades made by institutional investors.
It is not yet clear how much of this cost will be passed on to
the clients of a bank in the form of increased transaction cost
and, therefore, the implicit cost of this extra capital for a
particular trade is uncertain at this time.
We expect that EU member states will begin to transpose
CRD IV in the second half of 2013, leading to the
simultaneous implementation of the Regulation and Directive
targeted for 1 January 2014 (see Figure 2 below).
Figure 2: CENTRAL CLEARING AND RISK MITIGATION MECHANISMS IMPLEMENTATION TIMELINE
[ 10 ]
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN
2013 2014
March 2013
Rules on
timely
confirmations
and mark-to-
market model
for bilateral
trades
Sept. 2013
Rules on portfolio
reconciliation,
portfolio
compression and
dispute resolution
for bilateral trades
Sept. 2013
Earliest date for IRS
& CDS reporting
Jan. 2014
Earliest
expected date
for CCP
authorisation
and start of
frontloading
period
Q2 2014
Estimated start of
the clearing
obligation for IRS
& CDS
Aug. 2015
Earliest
expiry of
pension fund
clearing
exemption
AUG
2015
Markets in Financial Instruments Directive II
/Regulation (MiFID II/MiFIR)
The MiFID Review should precipitate a greater proportion of
trading on organised trading venues, including stock
exchanges. It also seeks to address perceived deficiencies
from MiFID I, such as the failure to deliver a consolidated
tape for equity and the continued barriers to connectivity
between and across European market infrastructure.
Politically emotive issues such as “dark pool trading” and high
frequency trading (HFT) have dominated the negotiations up
to this point. MiFID II is still under discussion, but a final
agreement could be reached by the second half of 2013. We
detail below what we believe to be the most likely outcomes.
Market Infrastructure
OTF: A new trade execution category called Organised
Trading Facility (OTF) will be introduced, but its scope is
still to be determined. It will capture a significant part of
trading previously deemed OTC and not initially caught in
the current MiFID regime. It will further ensure that all
trading venues (broker crossing systems and "dark pools"
included) have the same standards of disclosure and
reporting as other trading venues. This will provide greater
choice of organised trading venues to better facilitate best
execution of client orders. A harmonised disclosure and
reporting regime for all venues will improve information to
the market, which will increase investors’ ability to make
better-informed investment decisions.
HFT: HFT operators, mainly market makers, will have to
provide liquidity to the market on a continuous basis. This
will be beneficial for investors as long as HFT is
appropriately and clearly defined in the final rules and does
not include algorithmic trading carried out by participants in
markets, including asset and pension fund managers, to
execute transactions. Otherwise, these would be obliged to
set themselves up as market makers. Other prudential and
organisational requirements for the wider category of
algorithmic trading is expected to be introduced.
Market access and interoperability: While not perceived
as a major focus of the buy side, infrastructure connectivity
is perhaps the most politically charged of issues within the
MiFID review and, therefore, it is difficult to predict the final
outcome at this juncture. Barriers to access between
trading venues and to the clearing and settlement layers
ultimately fragment liquidity and create costs. The costs of
fragmented liquidity and the costs of listing on multiple
exchanges, coupled with the associated costs of the
respective and often captive clearing and settlement of
securities, is borne by end-investors and ultimately is a
drag on investment performance.
Pre- and Post-trade Transparency
Pre- and post-trade transparency requirements, imposed
currently only to equities admitted to trading on regulated
markets, will be introduced for other instruments, including
fixed income, structured finance products and derivatives and
across all trading venues. The new regime is likely to be
tailored to the instruments in question and not be a simple
“copy-paste” from the current equity transparency regime.
However, it is still to be decided how the new transparency
regime for non-equity will be calibrated. Unlike equity, the
“non-equity space” is extremely diverse, typically fragmented
and inventory-based, and is characterised by low or dispersed
liquidity. A “one-size-fits-all” transparency regime for all non-
equity instruments could stifle liquidity and make these
markets less efficient.
Pre-trade transparency requirements: Market
participants will have to disclose the bid and offer price of
any non-equity instrument transactions on which all clients
will have an equal access, regardless of settlement risk,
market liquidity and each market maker’s particular risk
limits. Depending on the size and the liquidity level of the
non-equity instrument in question, buyers and sellers could
be less willing to reveal quotes to the whole market for fear
they find themselves in a weak bargaining position. Despite
this market reality, it is still uncertain whether regulators will
be able to use a waiver for specific types of instruments
based on market model, order size, liquidity or other
relevant criteria and apply a set of different waivers to
exempt some transactions from the transparency
requirements.
Post-trade transparency requirements: MiFID II will
deliver the long-awaited pan-European Consolidated Tape
(ECT) for equity and equity-like instruments such as ETFs.
The ECT will offer the most current information available,
with prices disclosed throughout the trading day, with a
comprehensive level of detail that may include a wide range
of securities and investment types. Sources of the data
contained on it can come from various securities
exchanges, market centres, electronic communications
networks, and even from third-party brokers or dealers. This
is clearly beneficial for end-investors, helping them get a
more complete picture of an equity instrument’s liquidity
across venues. This consolidated view of liquidity will
facilitate more informed price discovery and could well
precipitate increased liquidity cross-European markets. A
calibrated post-trade reporting system for fixed income,
loosely based on the existing TRACE model in the US2,
also will be implemented to capture European post-trade
data in these markets.
Political State of Play
The EC published in October 2011 proposals that aim to
update the existing regulatory framework in MiFID and
set up directly applicable requirements to be contained
in a new regulation known as the Markets in Financial
Instruments Regulation (MiFIR).
Political agreement on the review of MiFID likely will be
reached in the second half of 2013 and is then expected
to come into force by the first quarter of 2015.
[ 11 ]
Financial Benchmarks
The alleged manipulation and underreporting of the London
Interbank Offered Rate (LIBOR) has cast doubt on the
credibility of rate benchmarks. Given the wide use of these
benchmarks by investors and market participants, it is
fundamental for market stability that confidence in these
benchmarks be restored. As detailed in our March 2013
ViewPoint, “Best Practices for Better Benchmarks,”
policymakers globally are reviewing rate benchmarks,
including LIBOR and EURIBOR, and considering potential
reforms. Policymakers are also considering the extent to
which reform of submission-based rate benchmarks should
and could apply to transaction data-based market indices.
Use of Financial Benchmarks by Investors and Market
Participants
Rate benchmarks (such as LIBOR) and market indices (such
as DJ Stoxx 50 ETF) are used widely in the management of
investor portfolios. Benchmarks such as LIBOR, EURIBOR,
EONIA, SONIA and the Overnight Index Swap (OIS) provide
the interest rate levels that can be used as reference rates for
securities within a portfolio. The reference rate is used to
determine the coupon paid on a security of a fund, to
calculate coupon payments on a wide variety of securities
(including interest rate derivatives) with a floating rate
component, and as a purely indicative reference rate to
calibrate the expected performance of a fund.
Market indices, such as MSCI, FTSE, Russell, S&P/Dow
Jones, STOXX, Markit iBoxx, Barclays, S&P/Dow Jones
GSCI and DJ-UBS, differ in a number of important ways from
rate benchmarks. Market indices are typically more objective,
more transparent and more easily verifiable (and hence less
easily manipulated) than submission-based benchmarks.
There is competition among index providers, and asset
managers will actively look for benchmarks with the most
desirable characteristics. Passive asset managers (or index
managers) have to replicate these indices, rather than rely on
a reference rate, which is another key difference between
market indices and rate benchmarks.
Implications of Proposed Reforms on Investors and
Market Participants
There is debate in policymaking circles about replacing rate
benchmarks that are based on submissions by panels of
broker-dealers (“survey-based rate benchmarks”), like LIBOR
and EURIBOR, and assigning alternative benchmarks
mandated for specific activities. Although politically seductive
as a policy option, replacing submission-based rate
benchmarks would require the renegotiation of thousands of
existing contracts, which would represent excessive and
unnecessary costs for market participants as well as end-
investors, including corporations, municipalities and
individuals through their mortgage or other consumer
borrowing contracts. Also, hurried renegotiation of the existing
contracts may cause market dislocation and disruption.
Policymakers globally and at the European level have
included market indices in the scope of reform of rate
benchmarks. BlackRock supports regulation of benchmarks in
terms of sanction and transparency. However, we remain
cautious about a far-reaching regulatory regime for market
indices since this would likely result in significant additional
costs for index providers. The costs would ultimately be
passed onto the end-investor, undermining the core benefits
of low-cost passive funds, while presenting barriers to entry
for new market participants. This, in turn, undermines the
healthy competitive environment that exists in the market
index space today.
We believe there is a balance to be struck between
meaningful reform of benchmarks and minimal disruption to
markets and/or increased costs borne by end-investors. Our
proposals include the following:
Focus on the shorter tenors and the maturities most
representative of bank funding activity (e.g., to discontinue
a number of currencies and maturities of LIBOR where
there is a lack of transaction data and after existing
contracts based on those benchmarks have all been
resolved).3
Augment subjective submission data with the explicit use of
transaction data, where available (with private reporting,
time lags and/or aggregation as appropriate), at least until
there are acceptable alternatives to submission-based
benchmarks.
Strengthen regulatory oversight and supervision, including
a binding code of conduct for rate benchmark submitters
with enhanced transparency and disclosure for investors
(subject to independent audit), coupled with sanctions in
case of market manipulation.
Support enhanced disclosure requirements that help end-
investors understand both the components and the relevant
risks of index-tracking products. Ultimately, the goal must
be to ensure end-investors understand how indices are
constructed and the risks associated with index-tracking
products, while retaining access to a broad selection of
investments.
Consider enacting a code of conduct whereby market index
providers to public securities commit to a high level of
transparency and conduct. Such a code would help
investors clearly understand whether a given index is: (i)
representative of its opportunity set; (ii) investible; and (iii)
sufficiently diversified.
[ 12 ]
At the same time, we believe the reform agenda should
include an explicit objective to allow market evolution. In
pursuit of that end, it is important that an ample transition
[ 13 ]
period to implement any reform be allowed to minimise
market disruption and forced renegotiation of thousands of
existing contracts.
Political State of Play
Financial benchmark reform is being considered by
multiple regulators worldwide, including the Commodity
Futures Trading Commission (CFTC), IOSCO, the EC,
ESMA and the European Banking Authority (EBA).
Additionally, Martin Wheatley, CEO of the Financial
Conduct Authority (FCA), was commissioned by the
Chancellor of the Exchequer to undertake a review of
LIBOR, culminating in the comprehensive “Wheatley
Review of LIBOR.” Mr. Wheatley and CFTC Chairman
Gary Gensler co-chair the IOSCO Board Level Task
Force on Financial Benchmarks.
There is still uncertainty as to when the reforms will be
effective, but we expect specific reform proposals to be
developed over the course of this year.
Additionally, a number of policymaking bodies have
extended the review of LIBOR and EURIBOR to other
types of financial benchmarks, such as market indices
(e.g., the MSCI World Index).
Please see related ViewPoint, “Best Practices for Better
Benchmarks: Recommendations for Financial Benchmark
Reform” for more on this topic.
Financial Transaction Tax (FTT)
The Financial Transaction Tax (FTT) has been a high-priority
item for many European policymakers in the aftermath of the
financial crisis. A number of EU regulators share the political
belief that the tax will force financial institutions to help pay
for the cost of the financial crisis; curb speculation, risk taking
and high frequency trading; and raise additional public
revenues.
France, Italy, Spain and Portugal are implementing or have
already implemented an FTT at the national level (see Figure
3). These countries, along with Austria, Belgium, Estonia,
Germany, Greece, Slovakia and Slovenia, are simultaneously
making progress toward the adoption of a common FTT
under an enhanced cooperation regime, forming an “FTT
zone”, which will supersede national FTTs when put into
force.
Scope and Extraterritorial Reach
In early 2013, the EC published a proposal for a common
FTT under the enhanced cooperation regime. The scope of
this proposal is very broad. Both the purchase and sale4 of
any instrument negotiable on the capital market (shares and
bonds), as well as derivatives contracts, will be taxed. All
financial institutions will be chargeable under two conditions:
1. If one party of the transaction is established in an FTT zone
member state (residence principle);
2. If the underlying transaction has been issued in an FTT
zone member state (issuance principle).
In other words, financial institutions based in an FTT zone
country will pay the tax on any transactions they carry out,
while financial institutions domiciled outside the FTT zone will
be chargeable as soon as they trade with a party based in the
FTT zone or make a transaction on an FTT zone-issued
instrument. Branches of financial institutions outside the FTT
zone will be deemed within the zone if the institution’s head
office is domiciled there.
There are few exemptions from the tax. Primary market
transactions, transactions with central banks in the EU
member states and the European Central Bank or carried out
as part of restructuring operations, as well as transactions
made by Central Counterparties (CCPs), Central Securities
Depositaries (CSDs) or International Central Securities
Depositories (ICSDs) are exempted. However, there is no
exemption for market making, pension funds, collateral
transactions and securities lending and repo. Increasingly,
these are being seen as controversial and untenable features
of the proposed tax.
The amount of tax ultimately paid for a single financial
transaction is expected to be higher than the minimum tax
rates currently proposed (0.1% of securities’ value and 0.01%
of derivatives notional). No relief is given to the intermediaries
involved in the financial transaction chain. The FTT has the
potential to apply to all movements of securities between
these parties. For example, the tax will apply to every link of
the asset management value chain, including primary
distributors, sub-distributors, transfer agents, fund vehicles,
brokers and counterparties.
Costs for Investors
It is widely recognised that the FTT will be predominantly and
directly paid by investors and not the financial sector itself.
The FTT will be passed on to end-investors in the form of
reduced fund performance (i.e., the performance of any
investments made by fund managers in the FTT zone or on
FTT zone-issued instruments will be hit by the FTT, reducing
fund performance gains directed to end-investors).
To give a few concrete examples, MMFs and short-term fixed
income funds will be severely penalised, as they will pay the
tax on a far greater number of transactions. The FTT
threatens to make securities lending risks economically
unviable. This would further undermine fund performance, as
it is likely that any revenue generated when a fund lends a
number of its securities will not exceed the cost of the FTT.
Also, sound asset management principles such as diver-
sification, proper hedging and efficient execution will be
undermined, exposing end-investors to greater investment
risk, particularly in volatile markets. in order to deliver the
same level of returns to clients, active portfolio managers will
be forced to take higher levels of risk and/or invest to a
greater extent in derivatives, as these instruments will be less
expensive to invest in than securities.
We are concerned that the asset management industry in the
FTT zone will be significantly damaged, and FTT zone
countries are likely to cease to be viable fund domiciles for all
but those funds investing in local assets. Fund activity, and
ultimately the fund management infrastructure that supports
the current fund activity and distribution platform, will decline
within the FTT zone. The proposed tax would ultimately be a
significant blow to the attractiveness of the EU as an
investment location compared to other regions such as Asia.
Taxation
[ 14 ]
Political State of Play
In September 2011, the EC published a proposal for the
introduction of an EU-wide FTT. Given the strong
opposition from the UK, the Netherlands, Sweden, Ireland,
Luxembourg, Czech Republic and Malta, the EU countries
in favour of an FTT opted to follow the enhanced
cooperation procedure and/or implement their own FTT at
a national level.
The characteristics of the FTT under the enhanced
cooperation procedure are currently being discussed
among the 27 member states (only the 11 member states
involved in the enhanced cooperation procedure have a
vote on the proposal; the 16 non-participating countries
may participate in the discussions on the FTT, but they
may not vote).
COUNTRY OUTLINE OF FTT KEY DATES
France
Shares - 0.2% tax on shares (all shares issued by a French company with a market capitalisation>=€1bn)
Tax due by investment firm executing orders; CSDs if transactions did not take place through an
investment firm; and the intermediaries
Primary market issuance; CCPs and CSDs; market making activities; intra-group transactions; sec lending
and convertible bonds exempted
HFT - 0.01% tax on all HFT firms trading on own capital with operations in France if they are trading on
shares (when order cancellation/modifications>= 80%, the tax applies on all cancelled or modified orders)
Market making activities exempted
CDS - 0.01% tax on naked EU sovereign CDS, when bought by an entity with operations in France
Market making and securities lending and repo exempted
Adopted on
31/7/2012
(started
applying to
transactions
from
1/8/2012)
Italy
0.2% tax rate (0.22% for 2013 only) for shares and equity-like instruments traded OTC, and 0.1% (0.12%
for 2013 only) for those traded on regulated platforms (all shares issued by listed Italian companies and
family-owned and publicly held companies (companies with market cap < €500m excluded)
Tax rates differ for derivatives depending on the type and the notional value and will be higher for
transactions taking place outside the regulated markets
HFT - 0.02% levy on high frequency transactions on equities and derivatives executed through an
automated processing system in which a computer algorithm automatically determines the various
parameters of the orders
The tax is paid by the one who receives the order to execute the transaction directly from purchaser or
final counterparty
The tax will apply also to transactions between non-Italian intermediaries, as it is based on an issuance
principle for both securities and derivatives
Market making, pension funds, securities lending and repo and UCITS qualified as “ethical” or “socially
responsible” are exempted
Live dates:
1/3/2013
(equity) and
1/9/2013
(derivatives)
Spain
On hold
Spanish authorities in 2012 tabled a proposal for an FTT that bears similarities to the French FTT model.
However, the proposal was not included in the 2013 Budget Law.
0.2% tax on certain shares, HFT and naked EU sovereign CDSs
Market makers exempted
Supposed to
go live mid-
2013
(now unlikely)
Portugal
On hold
2013 budget law contains authorisation for the government to legislate on the introduction of an FTT. The
legislative authorisation is valid for the period of one year.
Expected rates, proposed by the government: 0.3% for general transactions, 0.1% for HFT transactions,
0.3% for derivatives transactions
Supposed to
go live mid-
2013
(now unlikely)
Figure 3: EU DOMESTIC FTT
The final outcome is likely to be very different from the
initial FTT proposal given the level of disagreement
among the 27 member states on the scope of the FTT
and the use of the proceeds of the FTT. The 11 member
states must decide on the final form of the FTT by
unanimity.
The UK recently opened a legal challenge to the EC
proposal denouncing its extraterritoriality. The court case
seeks to create some degree of influence to those outside
the FTT zone in setting the agenda of the negotiations.
FTT implementation is currently planned for 1 January
2014 at the earliest, but political agreement among the
countries involved is not likely to be reached by then.
[ 15 ]
[ 16 ]
Foreign Account Tax Compliance Act (FATCA)
The Foreign Account Tax Compliance Act (FATCA) aims to
improve information reporting on US taxpayers to prevent tax
evasion. FATCA requires Foreign Financial Institutions (FFIs),
i.e., local banks, asset managers, fund distributors, fund
administrators and collective investment vehicles, to identify,
report US account holders and withhold on certain payments to
the Internal Revenue Service (IRS). FFIs that do not comply are
subject to a 30% withholding tax on US-sourced income and
gross proceeds on the sale of US securities.
FATCA covers US-domiciled funds held by non-US investors
and non-US funds that invest in the United States, as well as
segregated accounts. Certain FFIs are exempted, as outlined
in Figure 4.
Two IGA models exist at this time. The first allows FFIs to
report information on US account holders directly to their local
tax authorities, who would then report onwards to the IRS.
The second allows reporting of existing US accounts and non-
participating FFIs to be reported in aggregate form directly to
the IRS, where consent to give individual information is not
given. One of the main benefits of an IGA is that all FATCA
withholding obligations are removed for funds in the first IGA
model. It could still apply in certain circumstances in the
second model, where personally identifiable information for
existing investors is requested by the IRS but consent to
provide this is not obtained. The first model will be more
widely adopted; however, of the above mentioned
jurisdictions, Switzerland has signed the second model.
Investor Considerations
Overall, the introduction of IGAs is welcome news for
investors. Where implemented, all entities within an IGA
jurisdiction initially will be presumed compliant with the rules.
Moreover, in general, financial institutions in IGA countries do
not need to withhold against their clients. In other words, the
very real financial risks to end-investors under the original US
proposal are largely removed. The onus is now on the
industry to implement the procedures required to comply.
Investors will, in due course, be able to verify for themselves
whether the intermediaries they are dealing with and the
funds in which they invest are compliant. A registration portal
will be accessible for registration to financial institutions
beginning no later than 15 July 2013, and the IRS will post the
first list of FFI compliant entities on 2 December 2013.
Thereafter, the list will be updated monthly.
FATCA-like Regime in the EU
Germany, France, the UK, Italy and Spain have announced
they will exchange information on clients of asset managers
and other financial firms in their jurisdiction to combat tax
evasion. Reports indicate that the Netherlands, Poland,
Romania and Belgium intend to join. We believe the current
proposals will mainly create new monitoring and reporting
requirements for fund firms: They will only be required to code
an account as German, French, UK, Italian or Spanish and
report to the relevant national authorities in the five
jurisdictions, which will then exchange information. This may
evolve into a broader European agreement over time, but
may never become a true European FATCA that would place
requirements on third-country investors as a condition of
investing into Europe, in the way the original US FATCA
does. Some commentators suggest that as fund managers
have already adapted their systems to be compliant with
FATCA, they will easily be able to meet the terms of these
new requirements. We believe such a conclusion cannot be
reached until the final rules are fully clarified. Ultimately,
BlackRock remains supportive of any outcome that is both
practical and effective in reducing tax evasion.
Total
Exemption
Total
compliance
Exempt Beneficial Owner (e.g., certain
institutions for occupational retirement provision)
Certified Deemed Compliant (e.g., certain
charities and non-profit organisations,
sponsored, closely held investment vehicles and
limited life debt investment entities (transitional)
Registered Deemed Compliant (e.g., restricted
funds 5, local FFIs6 and QCIVs7)
Compliant but with Exempted Accounts
(e.g., UK banks providing ESAs)
Fully compliant (PFFIs)
Figure 4: FATCA EXEMPTION STATUS
The final FATCA regulations were released on 17 January
2013 and apply to non-IGA (Intergovernmental Agreements)
jurisdictions.
Intergovernmental Agreements (IGAs)
To reduce the burden of implementation and to overcome the
data protection law barriers in certain jurisdictions,
Intergovernmental Agreements (IGAs) have been negotiated
between the IRS and relevant foreign governments. The IGA
defines the approach to FATCA compliance for FFIs in that
jurisdiction. Having FATCA enforced as a national law in
these countries will also raise the ability of national authorities
to tailor FATCA to the individual country’s specificities.
To date, nine jurisdictions have signed an IGA (UK, Spain,
Denmark, Ireland, Norway, Switzerland, Mexico, Germany
and Japan). The UK has taken the lead in the development of
draft regulations and guidance to implement FATCA in its
jurisdiction, and it is expected that other IGA jurisdictions will
use these as a model. France, Germany and Italy are close
to finalising their agreements, while Luxembourg has yet to
start negotiating with the IRS. At this juncture, we do not have
full clarity, as many jurisdictions have yet to sign an IGA or
confirm that such an agreement will not be signed.
Bank Regulation
Excessive and off-balance-sheet leverage, coupled with
inadequate levels of bank capital, combined to create the
2008 systemic crisis. Policy action since then has centred on
repairing bank balance sheets and strengthening the
prudential regulatory framework in which banks operate. A
policy focus on bank recovery and resolution, including the
role investors could play in re-capitalising failing banks in the
future, remains a topic of intense debate in Europe.
Basel III/CRD IV
The global Basel III principles will require banks across the
globe to increase the quality and quantity of their capital as
well as the amount of capital held against their counterparty
credit risk arising from exposures on derivatives, repos and
securities financing activities. Banks also will be subjected to
a Credit Valuation Adjustment (CVA) risk capital charge (see
page 9, “Regulation of OTC Derivative Markets”), leverage
limit and higher liquidity standards. A capital surcharge and a
countercyclical capital buffer also will be imposed for
Systemically Important Financial Institutions (SIFIs)8, which
are financial institutions whose failure could generate a
financial crisis.
In Europe, Basel III will be adapted to the European market
and its legal specificities, and implemented through the Credit
Requirements Directive IV (CRD IV) and the Credit
Requirements Regulation (CRR). This legislation will
encompass roughly 8,000 banks operating in Europe and is
expected to be fully in force by 2018.
Recovery and Resolution Regime
The political objective of the recovery and resolution regime
is to limit taxpayers’ potential exposure to failing banks in the
future. Arguably, given this year’s events in Cyprus, there is
now also a political focus in some quarters to limit depositors’
exposure to bank failure, which is likely to be at the expense
of senior unsecured bondholders. In Europe, this will be
implemented through the forthcoming Bank Recovery and
Resolution Directive (BRRD).
Recovery plans detail the actions a firm would take to avoid
failure by staying well-capitalised and well-funded in the case
of an adverse event. The goal is to identify preventative
actions to ensure an institution never reaches the point of
non-viability (PoNV), thereby allowing firms to continue to
operate as a “going concern”. These actions could include
selling subsidiaries or certain business lines.
Resolution plans, by contrast, are designed to facilitate
actions by the relevant authorities to minimise any impact to
the wider financial system after the PoNV. In resolution, the
relevant authority is granted the power to close, liquidate or
otherwise resolve a failing institution, mandating investors
(both equity and senior bond holders) to bear all losses – by
having the bonds they hold written down or converted into
equity (“bail-in”) – limiting the exposure for taxpayers.
Implications of Banking Regulations for Investors
The implementation of Basel III in Europe will strengthen bank
balance sheets, insulating investors in bank securities from
future losses. These measures should help to restore investor
confidence in the banking system and facilitate investors’
predictability on banks’ earnings, provided there is clarity on
how capital requirements will be implemented by the banks.
In case of an idiosyncratic adverse event, problems can
ideally be addressed with a recovery plan. In situations where
recovery is not possible, resolving failed institutions after the
PoNV could preserve critical functions and stabilise asset
prices in times of distress.
However, the theoretical possibility that bondholders could be
“bailed-in” as part of a bank recovery and/or resolution
process creates a degree of uncertainty and leads to
heightened caution on the part of investors. If it becomes
increasingly difficult for investors to assess risk of investing in
bank securities, this will impact consistency and quality of
pricing. Hence, clarity and predictability of recovery and
resolution regimes are critically important features to facilitate
the continued investability of banks.
It is also very important that the creditor hierarchy is
preserved with respect to senior secured, senior unsecured,
subordinated and equity claims in a resolution framework.
While haircuts in resolution may avoid liquidation valuations,
debt investors may be unwilling to tolerate significant or total
loss while common and preferred equity remains outstanding.
Maintaining a strict loss absorption waterfall during resolution
increases investors’ confidence in their risk/reward
assumptions at all levels of the capital structure.
Effective international coordination and cooperation to set up
a global level playing field between various regulators on: i)
the triggers for entering resolutions; ii) the scope of resolution;
iii) the path by which the institutions may be resolved; and iv)
the requirements for bail-in-able securities and their terms
would further enhance the prospects for volume investing in
bank securities.
Investment & Asset
Allocation
[ 17 ]
Political State of Play
CRD IV – The EC published a proposal on CRD IV in
July 2011 divided into a Directive and a Regulation. We
expect that EU member states will begin to transpose
CRD IV in the second half of 2013, leading to the
simultaneous implementation of the Regulation and
Directive targeted for 1 January 2014.
BRRD – The proposal for BRRD is currently under
negotiation. Agreement on the framework legislation is
anticipated in 2013, although implementation of many
powers is not slated to be effective until January 2015,
and January 2018 in the case of bail-in for senior
creditors.
[ 18 ]
Solvency II
Solvency II is the proposed prudential regime for most EU
insurers and reinsurers as well as many international firms
conducting business within the EU. It aims to align each
undertaking’s solvency capital with the risks inherent in its
business – taking into account current developments in
insurance, risk management, finance techniques, international
financial reporting and prudential standards. Insurers across
the EU have been preparing for the implementation of the
Solvency II Directive against a backdrop of on-going
uncertainty regarding the policy details and the timeline of its
implementation.
Impacts on Insurers’ and Reinsurers’ Risk Management
The regime will set provisions for the amount of capital that
insurers and reinsurers will have to hold against each type of
market risk. It will also impose the “prudent person principal”,
which requires firms to invest only in “assets and instruments
whose risks it can properly identify, measure, monitor, ma-
nage, control and report” and to invest in a manner that
ensures the “security, quality, liquidity and profitability of the
portfolio as a whole”. With the potential exception of long-term
guarantee liabilities (LTGs), a Pillar 1 issue focussed on capi-
tal requirements and liability valuation, Solvency II will require
the valuation of assets and liabilities at fair market value.
Solvency II also will require firms to conduct an Own Risk
Solvency Assessment, which aims to cover a company’s
internal risk management processes and procedures as well
as an assessment of its own solvency requirements.
Supervisors will require reconciliation between an insurer’s
internal assessment of capital and the Pillar 1 Solvency
Capital Charge.
Impacts on Insurers’ and Reinsurers’ Asset Allocation
The impact of the proposed Solvency II measures on asset
allocation is very difficult to assess given the on-going debate
regarding the LTG provisions and the potential effect of
internal models. Nevertheless, there is an increasing
expectation that internal models will only be approved by
regulators if they result in similar capital charges from those
under the standard model. This is likely to lead to a relative
allocation toward government bonds and investment-grade
credit from equity, property and alternatives. The current
“zero-rated” charge for government bonds looks even more
untenable given the “credit spread-like” marked-to-market
volatility many government bonds have exhibited over the
past three years.
Issues Related to Pillar 2 and Pillar 3 Requirements for
Insurers and Reinsurers
Insurance companies remain concerned about meeting the
requirements regarding timeliness, completeness and quality
of data from third parties under Pillar 3. They also remain
anxious that they will have to limit their investment strategy,
as some assets demand more rigorous data reporting
requirements that will prove difficult to meet. Pillar 2
requirements further reinforce the importance of data in
Solvency II, as insurers need to demonstrate the quality
control around data and justify their risk measurement
approach in Own Risk Solvency Assessment.
Political State of Play
The implementation of Solvency II is likely to be delayed
until 2016 or later. The main issue remains treatment of
the LTG. The European Insurance and Occupational
Pensions Authority (EIOPA) launched an LTG impact
study covering 13 potential combinations of scenarios
for matching adjustment, ultimate forward rate,
countercyclical premium and transitional measures. The
European Parliament plenary vote is scheduled to take
place in October this year (originally in June), but it is
not guaranteed that an agreement will be reached on
time.
Some believe the vote may never happen, as it did not
happen in June (as previously planned). There is a
concern that fragmentation among member states as
national regulators start to apply different aspects of the
regulation to their own industry. In an effort to avoid this,
EIOPA published in March its “Consultations on
Guidelines” outlining how to prepare for Solvency II.
Final guidelines are expected by autumn 2013 and
regulators will have to notify EIOPA whether they will
comply with the guidelines within two months of
publication or not. Guidelines are expected to apply from
1 January 2014.
The EC recently requested that EIOPA examine
whether the calibration and design of regulatory capital
requirements for insurers’ long-term investments
necessitates any adjustment or reduction. In response,
EIOPA published a consultation on its preliminary
findings and suggestions on this issue.
Institutions for Occupational Retirement
Provision Directive (IORPD)
The EC initiated a review of the Institutions for Occupational
Retirement Provisions Directive (IORPD) in an effort to
harmonise pension schemes at the EU level, to facilitate the
portability of workers’ pensions across EU member states
and to increase IORPs’ risk mitigation mechanisms in order
to boost security for beneficiaries. The EC also is seeking a
more level playing field with insurance companies by applying
the so-called Solvency II Pillar 1 framework on capital
adequacy – with some adjustments – to pension schemes.
However, Commissioner Michel Barnier announced in May
2013 that the IORP legislative proposal scheduled for
September 2013 will focus on governance and transparency
issues and not on capital requirements.
Given the impact capital requirements might have on pension
schemes, we have detailed an analysis of capital
requirements below, and how they may affect end-investors.
The EC’s definition of an IORP is any “institution, irrespective
of its legal form, operating on a funded basis and established
separately from any sponsoring undertaking or trade for the
purpose of providing retirement benefits in the context of an
occupational activity on the basis of an agreement or contract
agreed individually or collectively between the employer(s)
and employee(s) or their respective representatives, or with
self-employed persons, in compliance with the legislation of
the home and host member states, and which carried out
activities directly arising from that purpose.”
The main options for pension funds on risk mitigation
currently proposed by ESMA are:
Market-consistent valuation with capital charges for holding
risk assets;
Use of the risk-free discount rate for liabilities; and/or
Adoption of the so-called “holistic balance sheet approach”,
a new method of valuing pension funds’ financial
exposures that takes into consideration the specific
characteristics of pension funds. This method includes a
valuation of sponsor covenant and pension protection
schemes, which are currently unrecognised assets in the
pension schemes’ balance sheets.
Applying this Solvency II-like prudential regime to IORPs
would require new common funding rules, potentially
resulting in a significant increase in fund liabilities. The
National Association of Pension Funds (NAPF) has estimated
that this legislation could add as much as £330bn to the £1.2
trillion existing liabilities of UK defined-benefit (DB) schemes.
An increased financial burden could reduce pension benefits
and/or lead to the accelerated closure of DB pension
schemes. In addition, a funding shortfall against the solvency
capital requirements levels is probable, altering asset
allocations and potentially shifting capital away from risk-
bearing assets such as equities.
The capital requirements imposed on different asset classes
in the holistic balance sheet approach might also have macro-
economic consequences. Overall, the amount of capital
available for investments will remain the same (or increase if
higher solvency requirements are in place), but the
distribution of this capital may change. There could be a
switch out of equities, but it is not clear where this capital may
be redeployed. If the capital is recycled to the corporate
sector in the form of corporate bonds, the impact on capital
available to the private sector may be minimal. However, if
more capital is directed to sovereign bonds, there may be a
reduction in the available capital for the private sector.
BlackRock recommends that the potential macroeconomic
consequences arising from such asset allocation changes be
considered in combination with other regulatory changes.
Finally, the key question of what happens when a shortfall is
calculated against the required capital remains unanswered in
the previous Pillar 1 IORPD proposals. As long as this
question is not addressed, the impact of the IORPD proposals
on pension schemes, sponsors and the wider economy will be
unclear.
Political State of Play
At the end of May 2013, Commissioner Barnier
announced he will not introduce a new capital regime for
occupational pension funds as part of his pensions
review.
The Commission has planned improvements to be
made in three key areas:
− Solvency: Implicit level playing field argument. As
with the future application of Solvency II, insurers who
provide occupational pension will be subject to stricter
capital requirements. This should also apply to
occupational pension funds to “guarantee fair
competition.”
− Governance: There are gaps in the current Directive
regarding the issues of internal risk management and
control systems.
− Transparency: There are varying differences in
existing systems between member states and the
issue of home/host supervisor needs clarification.
The new Directive (expected to be published in
September 2013) will focus only on governance and
communications.
[ 19 ]
Corporate Governance
Shortcomings in the corporate governance of listed
companies and financial institutions are considered by many
policymakers to have exacerbated the financial crisis.
Improvements in corporate governance are regarded as
critical to restore public trust and investor confidence in the
management of companies.
In December 2012, the EC published an Action Plan on
European Company Law and Corporate Governance. Most of
the actions proposed involve soft law obligations and act as a
road map for future actions. The objectives of the Action Plan
are to:
Enhance transparency of institutional investors about their
voting and engagement policies;
Greater engagement by shareholders on corporate
governance;
Support companies’ cross-border operations to increase
their competitiveness; and
Establish a pan-EU company law code.
Since the Action Plan, reforms have mainly progressed in
two areas:
The Corporate Governance Framework with arrangements
to make “the comply or explain” approach more efficient
(listed companies must comply with the Corporate
Governance Code applicable in the country in which they
operate, or otherwise disclose which sections they have
decided not to apply and explain why); and
The Shareholders’ Rights Directive with multiple proposals
on transparency of voting and engagement policies,
executive remuneration, related party transactions and
proxy advisors.
Both proposals are expected to be released later this year.
We find the second suite of reforms to be of greater
relevance for our clients. As such, we will focus our
comments on the provisions in the Shareholders’ Rights
Directive, particularly on the proposals regarding: (i)
transparency of investors voting and engagement guidelines
and disclosure of voting records by investors and of
companies and (ii) shareholder engagement.
Transparency by Institutional Investors on Their
Corporate Governance Activities and by Companies
The European Commission is concerned with a lack of
transparency and accessibility by institutional investors on
their voting policy that guide their voting decision in the
companies which they invest in. Regulatory steps are likely to
be taken to address this concern in the upcoming
Shareholders’ Rights Directive. In particular, the Commission
intends to establish rules of disclosure by institutional
investors of their voting and engagement policies to enable
end-investors to optimise their investment decisions and to
progress the dialogue between companies and their
shareholders.
Other initiatives, some related to transparency required from
companies, deal with the disclosure by investee companies of
their board diversity policy and of their non-financial
information. The question of shareholder identification
(issuers being able to know the identity of share owners) will
be addressed in the Securities Law Legislation.
BlackRock provides its clients with regular reports on how we
vote on their behalf (when asked), as well as quarterly
commentaries outlining market developments and noteworthy
voting and engagement. As a US-domiciled company, we file
our voting record with the US SEC each August, and post it
together with an annual review of our corporate governance
activities on our website. We rarely make public statements or
publicly disclose details of specific engagements; our
preference is to engage privately with companies. This
approach, we believe, enhances rather than hinders dialogue.
Shareholder Engagement
The EC seeks to strengthen shareholders’ role in promoting
better governance of companies by increasing interaction with
investee companies’ management. Some proposals to
achieve this have been detailed above and others are
developed below:
A binding vote on pay: The EC seeks to grant
shareholders the right – or duty – to vote on the investee
company’s remuneration policy and remuneration report.
This has attracted a lot of attention over the past few years.
We agree that a binding vote is likely to incentivise
remuneration committees to structure pay arrangements in
line with shareholders’ interests but foresee a number of
unintended consequences for investors. First, even more
time will be spent on remuneration discussions with the
companies to the detriment of engagement on other
matters, such as strategy and execution, which are more
directly tied to long-term shareholder value. Second, the
responsibility for pay setting risks moving from the board
and remuneration committees toward shareholders.
BlackRock believes the responsibility should stay with the
boards and remuneration committees as they are best
placed to create effective policies that are appropriate for
their company.
Potential regulation on the proxy advisory industry:
The EC is looking at ways to improve transparency by
proxy advisers on the preparation of their advice and on
their management of possible conflicts of interest.
BlackRock believes the focus should be on transparency of
their methodology and identification and
[ 20 ]
our engagement when we do so and companies adjust their
approach. Change can also take time and we sometimes
support management on issues in the short term, while they
work through changes over the long term.
As a long-term investor, with significant investment in index-
tracking strategies, we are patient and persistent in working
with our portfolio companies to build trust and develop mutual
understanding.
We do not try to micro-manage companies; we present our
views as a long-term shareholder and listen to companies’
responses.
We will vote against management when we judge that direct
engagement has failed and when we think that to do so is in
our clients’ best long-term interest.
As a fiduciary, our responsibility, first and foremost, is to our
clients. It is not our priority, as we sometimes hear, to make
companies better. We believe protecting and enhancing the
value of the companies is the responsibility of the board of
directors and company executives. The two responsibilities
are often confused.
Market Abuse Directive
The EU market abuse regime is currently under review to
enhance and standardise sanctions taken to combat market
manipulation and insider trading. We strongly support the
aims of the market abuse regime to provide greater certainty
to investors that the markets in which they invest are being
properly policed and not abused. As highlighted by the EC,
there are, however, a number of provisions that lack clarity in
the new regime. Such opaqueness could prevent asset
managers from engaging with the companies in which they
invest on behalf of their clients, undermining efficient
corporate governance practices.
In particular, a new category of inside information has been
introduced that is defined in a way that is neither precise nor
price sensitive. Rather, it is a subjective test relating to
information that a reasonable investor would regard as
relevant when deciding the terms of a transaction. Without
tighter definitions, investors may be deterred from engaging
with companies for fear that many types of on-going
discussions on corporate governance could be construed in
the future as constituting inside information.
The EC’s proposals also do not contain adequate defences to
a new presumption that a person is deemed to have acted on
information if it is in their possession, even if the possession
was not material to their investment decision. The
Commission’s proposal requires that nobody in possession of
inside information relevant to any transactions had any
involvement in the transaction decision or behaved in such
management of conflicts of interest rather than on the
perceived influence proxy advisers have on investors’
voting outcomes. There is a high correlation between proxy
advice and voting outcomes, as the vast majority of
shareholder meetings and agenda items are fairly routine,
where shareholders are generally supportive of
management regardless of the proxy advisors’ advice. This
should not result in an assumed disproportionate influence
of proxy advisory firms on investors. Proxy advisory firms
play an important role in information gathering and in
highlighting areas of concern on which investors should
focus during their engagement with issuers. This allows
investors to devote efforts to additional research and
engagement. These benefits should not be undermined.
Related party transactions: These transactions consist of
dealings between the company and its directors or majority
shareholders (the “related party”), with the potential of
increasing their influence over the company to the
detriment of the company itself or its minority shareholders.
The EC is considering the need to give shareholders
greater oversight of related party transactions by imposing
safeguards. BlackRock believes the approval process
should safe guard against those that are not done on arm’s
length basis.
“Acting in concert”: The EC, along with national
authorities and ESMA, is seeking to clarify this concept,
which, in principle, enables shareholders to exchange
information and cooperate with one another. The legal
boundaries of this concept are currently unclear (such
cooperation can have unexpected legal implications). While
we have seen a notable increase in collective
engagements over the last two years, BlackRock believes
that greater legal certainty is needed to enhance effective
shareholder co-operation.
The Commission’s Green Paper on Long-term Financing for
the European Economy (more on page 22) contains
important provisions on corporate governance. It seeks to
incentivise shareholders’ long-term behaviour, possibly with
enhanced voting rights and/or dividends, as well as to
reinforce asset managers’ fiduciary duty.
BlackRock’s Philosophy on Engagement
Our role as a fiduciary means focusing on delivering long-
term value for shareholders – i.e., our clients. In our
experience, the most important factors in determining
success are the strong leadership and execution of a
company’s strategy. We believe the most effective means for
communicating concerns with management and boards is
through direct engagement. In 2012, we engaged with over
1100 companies around the world in preparation for voting at
their shareholder meetings. Most observers are not aware of
[ 21 ]
way as to influence the decision or had “any contact” with
those involved in the decision. This obligation would prevent
companies from effectively implementing information barriers,
such as Chinese Walls between different teams and
departments of an asset management company whereby
teams outside the wall can continue to deal while restricting
dealing by teams in possession of inside information. Taken
to an extreme, this could, for example, prohibit the
management of active and passive strategies within the same
company, as well as the work of centralised corporate
governance teams.
The proposals are currently under discussion and many
welcome improvements have been introduced by the
European co-legislators. An agreement on final rules appears
imminent, which would give more clarity on the definition of
inside information and on the possession and use of inside
information by investors.
Audit Regulation
The EC issued proposals at the end of 2011 seeking to
enhance auditor independence, audit quality and
transparency of financial statements, limit the influence of
auditors on listed entities and encourage greater competition
in the market for audit services. The proposals affect not only
listed companies, but many other entities falling within the
scope of the new public interest entity (PIE) definition
(including all investment funds and investment firms,
whatever their size or ownership structure). The new
requirements on statutory audits are expected to be
implemented in 2015.
BlackRock supports many of the proposals to improve the
quality of audit, especially the role of the audit committee and
the quality of the audit report. However, we recommend that
investment funds, both UCITS and AIFs, are excluded from
the definition of a PIE, as they are subject to on-going
oversight of assets by an independent depositary.
Another key provision of the audit proposals is for the
mandatory rotation of auditors every six years (or nine years
for firms with joint auditors). We are not convinced that
mandatory rotation will improve auditor independence and
instead strongly recommend regular mandatory tenders to
ensure that if an incumbent remains in place, they have
benchmarked against industry best practice.
Auditor rotation is likely to create a number of new risks,
including: a loss of auditor institutional knowledge; less
incentive for audit firms to invest in the audit relationship by
relocating the most qualified personnel or investing in travel
and training to learn the business; and potentially inhibiting
the audit committee in making its own decision as to the most
appropriate time to change auditors.
As an investor, BlackRock would be concerned, for example,
if a change of auditor was imposed during a major
restructuring, as this could lead to a reduction in the quality of
oversight at a critical time. Finally, for companies with a
significant non-EU presence, a forced rotation at a European
level could lead to global audit rotation.
Long-Term Investing
International and European policymakers are currently faced
with the challenge of finding ways to finance economic growth
against a backdrop of significant bank deleveraging. Initiatives
to drive growth are being spearheaded by the OECD and the
FSB on behalf of the G20 at a global level. In addition, the EC
launched a Green Paper on the "Long-Term Financing of the
European Economy” at the end of March with a number of
potential policy options.
Aims of the Green Paper
The Green Paper discusses a number of ways to increase
financing in key sectors of the European economy – those
sectors deemed most likely to drive future economic growth
and increase employment, such as infrastructure and small
and medium size enterprises (SMEs). Global policymakers
have not identified a single definition for long-term financing,
but, in its Paper, the EC defines it as investing in the
formation of long-lived productive capital (tangible and
intangible). European policymakers are seeking to diversify
long-term financing intermediation by increasing the role of
non-bank financial institutions such as pension funds,
insurance companies and asset managers in providing long-
term financing through capital markets. Examples given in the
Paper include infrastructure financing, project bonds, an
increased role for securitisations and the development of an
EU long-term investment fund (ELTIF) structure targeting
investment into illiquid assets by large and mid-range
institutional investors. The EC also identifies a number of
obstacles restricting the development of these additional
sources of long-term financing and the ability of
intermediaries to channel such financing to long-term
investments. There is a particular focus on whether prudential
capital requirements, such as Solvency II for insurance
companies, inhibit the development of long-term financing.
The policy framework also considers the governance
framework of institutional investors, focusing both on greater
transparency regarding their fiduciary duties and their
incentives to be long-term in approach. For example, a
number of options are currently under discussion to increase
long-term shareholder engagement. These include granting
multiple voting rights and linking dividend payments to long-
term investors.
[ 22 ]
Investors' Ability to Provide Long-Term Financing
Asset managers serve as key sources of capital to the
economy by providing investment solutions designed to allow
their underlying investors to finance future liabilities, which
often stretch many decades into the future.
As an asset manager, BlackRock recognises that focusing
purely on long-term investment, in other words on a buy-and-
hold strategy, may not always be in our clients’ best interests.
A long-term horizon can require evolving investment
strategies over time. Likewise, greater volatility in markets
may require the implementation of short-term strategies to
protect client interests. As investors, asset managers’ use of
loyalty dividends and multiple voting rights can be construed
as potential conflicts of interest between their clients and
companies.
Long-term investment strategies used by asset managers
include core strategies of investing in equities and bonds that
provide considerable amounts of capital to mainstream
issuers. Asset managers’ long-term focus involves
engagement with issuers to enhance value creation, hence
our focus on corporate governance (please refer to related
discussion on page 20). This is particularly true in the case of
index investing, which is, by definition, a long-term activity –
constituent securities in an index are held as long as that
security remains in the index. Many of these core investment
strategies provide daily liquidity within the investment vehicle.
This is key for individual retail investors who, in addition to
putting money away for the long term, generally also have
unpredictable short-term liabilities. Vehicles such as UCITS
meet both these needs.
Many investment opportunities related to long-term assets
identified by the EC, such as infrastructure and SMEs, are
specialist in nature, are not subject to public disclosure
requirements and do not lend themselves to easy
comparability and rating by institutional investors and other
third parties. They require detailed assessment by both
manager and professional investors. To develop the
necessary scale, they will be more suitable and attractive to
institutional investors, such as pension funds and insurance
companies, particularly if prudential regulatory requirements
are appropriately designed. Consistency of investor-focussed
regulation is, therefore, key to sustained future long-term
financing and economic growth.
BlackRock is investing heavily in the provision of long-term
infrastructure solutions, as the asset class is attractive to
institutional investors by providing inflation-protected yields
above government debt. It is also treated equally from a
capital risk weighting perspective to other equally long-term
investments. However, opportunities in long-term
infrastructure investment must meet a calibrated trade-off
between liquidity, risk and yield and cash flows similar to
liability cash flows (nominal or inflation linked). They must fit
within the investor's overall portfolio strategy, i.e. they must
add more value than other alternative investments. Also, the
product design must not create obstacles to investment in
terms of transparency and low fees, characteristics that are
consistent with regulatory or accounting requirements and
provide accurate long-term investment performance data.
Existing Fund Structures
The EC proposes a long-term investment fund vehicle
targeting illiquid investment by large and mid-range
institutional investors. In fact, institutional investors already
have access to a wide variety of fund structures designed to
reflect the often complex ways in which many illiquid assets
are held (e.g., any structure involving real property is likely to
have a number of overlapping leasehold and freehold
property rights). Taken as a whole, the variety of existing fund
structures is sufficient to meet the needs of institutional
investors. Therefore, we believe a pan-European long-term
investment fund product with strict guidelines as to asset
allocation or structure is unlikely to provide enough flexibility
to support the wide variety of institutional investor
requirements. We would support leaving such funds firmly
within the AIFMD regime, which already provides significant
benefits to institutional investors of a more standardised fund
governance and asset protection regime across Europe.
However, we do believe that providing AIFs that meet certain
criteria the opportunity to benefit from a pan-European
passport allowing them to access assets on a consistent
basis across the EU (e.g., consistent treatment on default or
insolvency of the underlying issuer) has the potential to draw
in increased pan-European capital flows.
Conclusion
BlackRock supports the creation of a regulatory regime that
increases transparency, protects end-investors, and facilitates
responsible growth of capital markets, while preserving
consumer choice and balancing benefits versus
implementation costs. BlackRock is keen to ensure that
policymakers’ thinking in Brussels and elsewhere remains
global, so that good practice can be adopted on a worldwide
basis. BlackRock, therefore, engages in the European
legislative process on issues with the greatest potential to
affect clients and seeks to ensure that high-quality technical
expertise is delivered in a timely manner. BlackRock delivers
technical advice across the breadth of its client base as it
seeks to become the independent global asset- and risk-
management partner of choice. We are concerned that a
large number of complex and interrelated proposals remain
on the table, in Europe and around the globe. We will
continue to be a vigorous advocate for end-investors with
regulators and lawmakers for policies that bring about positive
change for end-investors.
[ 23 ]
Endnotes
1 If a CCP is authorised to clear a certain class of derivatives by the relevant local regulator, transactions in such class of derivatives traded in the period from the
date of such authorisation and the date on which such asset class is mandated for clearing, are required to be moved to a CCP by the mandatory clearing date.
2 TRACE was launched in 2002 in the US to increase transparency in US fixed income securities. At that time, dealers were required to report all secondary OTC
market transactions in domestic public and private corporate bonds to TRACE. Government bond markets were subsequently considered sufficiently transparent
that TRACE reporting would not benefit the market and have since been excluded from reporting requirements. Dissemination from TRACE to the public also
started in July 2002. Over a period of about two years, the dissemination rules were expanded such that data on all publicly traded corporate bonds were made
available. FINRA initially gave 75 minutes for dealers to report into TRACE then gradually tightened the reporting window down to where it stands today at 15
minutes. The vast majority of trades are reported in near real time. TRACE reporting and dissemination for Agency bonds (e.g., Fannie Mae, Freddie Mac and
FHLB) began March 2010 and works similar to investment grade corporates.
3 In December 2012, the British Bankers’ Association (BBA) proposed the discontinuation by the end of December 2013 of a number of currencies and maturities.
The remaining reported currencies would include: Euro, Japanese Yen, Pound Sterling, Swiss Franc, and the US Dollar. The remaining reported maturities would
include: overnight/spot-next, one week, one month, three months, six months, and twelve months.
4 Sec lending and repo in scope (outbound leg only).
5 Restricted Fund: Funds that exclude US investors and can bind their distributors to do this. Restricted Distributor: Distributors who agree to participate in the above.
6 Local FFIs: Small and local distributors having a deemed compliant status.
7 Qualified Collective Investment Vehicle (QCIV): Funds having the deemed compliant status for only having PFFIs or exempted holders.
8 Factors for assessing whether a financial institution is a SIFI are based on the size, complexity, interconnectedness, lack of substitutability and global scope of a
financial institution.
FOR MORE INFORMATION
For access to our full collection of public policy commentaries, including the ViewPoint series and
comment letters to regulators, please visit:
http://www.blackrock.com/corporate/en-us/news-and-insights/public-policy
This paper is part of a series of BlackRock public policy ViewPoints and is not intended to be relied upon as a forecast, research or investment advice, and is not a
recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2013 and may change
as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to
be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising
in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.
This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and
forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.
Issued in Australia and New Zealand by BlackRock Investment Management (Australia) Limited ABN 13 006165975. This document contains general information only
and is not intended to represent general or specific investment or professional advice. The information does not take into account any individual’s financial
circumstances or goals. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to
talking to a financial or other professional adviser before making an investment decision. In New Zealand, this information is provided for registered financial service
providers only. To the extent the provision of this information represents the provision of a financial adviser service, it is provided for wholesale clients only. In
Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Hong Kong, this document is issued by BlackRock (Hong Kong)
Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. In Canada, this material is intended for permitted clients only. In Latin
America, this material is intended for Institutional and Professional Clients only. This material is solely for educational purposes and does not constitute an offer or a
solicitation to sell or a solicitation of an offer to buy any shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin
America in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this
material, it is possible that they have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico and Peru or any other securities regulator in
any Latin American country and no such securities regulators have confirmed the accuracy of any information contained herein. No information discussed herein can
be provided to the general public in Latin America.
The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation.
FOR MORE INFORMATION: WWW.BLACKROCK.COM
BlackRock® is a registered trademark of BlackRock, Inc. All other trademarks are the property of their respective owners.
© 2013 BlackRock, Inc. All rights reserved.